ANALYSIS Unilateral regulation of bilateral trade in greenhouse gas emission permits Katrin Rehdanz a, * , Richard S.J. Tol a,b,c a Research Unit Sustainability and Global Change, Hamburg University and Centre for Marine and Atmospheric Science, Hamburg, Germany, Bundesstrasse 55, 20146 Hamburg, Germany b Institute for Environmental Studies, Vrije Universiteit, Amsterdam, The Netherlands c Center for Integrated Study of the Human Dimensions of Global Change, Carnegie Mellon, University, Pittsburgh, PA, USA Received 21 October 2003; accepted 10 August 2004 Available online 4 February 2005 Abstract This paper considers the coordination of domestic markets for tradable emission permits where countries determine their own emission reduction targets, using a two-country model. Linking such schemes is beneficial to both countries but may cause the exporting country to decrease its emission reduction target and export more permits. This in turn would not only reduce the costs for both countries as less emissions have to be reduced, but it also lowers the environmental benefits of the importing country. One price instrument (tariff) and two quantity instruments (discount, quota) to prevent the exporting country from issuing more permits are examined. Each instrument restricts trade and alters the terms of trade for the two countries. The importing country (and regulator) prefers an import tariff and an import quota to a carbon discount. If the exporting country releases additional permits, the importing country should not try to keep total emissions constant, as that would be ineffective and maybe even counterproductive. Instead, the importing country should aim to keep the total import constant; this would impose costs on the exporting country that are independent of the policy instrument; an import quota would be the cheapest option for the importing country. An import quota would also stress the idea of supplementary of the flexible mechanism as it increases the share of emissions reduced domestically. Compliance and liability issues constrain the market further. However, both the importing and the exporting country would prefer that the permit seller is liable in case of non-compliance, as sellers’ liability would less constrain the market. D 2004 Elsevier B.V. All rights reserved. Keywords: Climate change; Emissions trading; Environmental effectiveness; Environmental integrity; Environmental policy; Liability and compliance JEL classification: Q540; Q580 0921-8009/$ - see front matter D 2004 Elsevier B.V. All rights reserved. doi:10.1016/j.ecolecon.2004.08.009 * Corresponding author. Tel.: +49 40 428387047; fax: +49 40 428387009. E-mail address: rehdanz@dkrz.de (K. Rehdanz). Ecological Economics 54 (2005) 397 – 416 www.elsevier.com/locate/ecolecon